Outsourcing agreements are always a new adventure and trying to find the best contractual arrangement is not easy. And this task is even harder in outsourcing agreements where the supplier provides a large part of the services and licenses necessary to run the business usually on the basis of a profit sharing arrangement. This situation might lead to relevant tax related risks because of the willingness of the supplier to control the business.
I had discussed in previous posts about legal issues in drafting outsourcing agreements with reference to the most appropriate contractual structure, limitation of liability clauses, intellectual property clauses, data protection clauses, forum selection and applicable law clauses, SLAs and penalties / liquidated damages and also in the insurance sector and as part of cloud projects.
But an issue that appears frequently in outsourcing agreements concerns deals where the recipient of the service is relying on the service provider in relation to a substantial part, if not all, of its business. This leads not only to fee arrangements prescribing almost an equal sharing of the revenues generated by the business, but also to considerable investments by the service provider that the latter is willing to protect requiring a control on management of the company receiving the service.
Which contractual structure for outsourcing agreements?
Under the circumstances above, the decision to be taken is whether the deal shall be structured as a corporate joint venture or a mere services agreement. In the former scenario, the service provider would become a shareholder of the company, will have its representatives seating on the board of the company and would be able to exercise its veto rights in the circumstances prescribed by the shareholders agreement.
However, such scenario would for instance prevent the recipient of the service from consolidating the financial accounts of the company within its group financial accounts. In fact most the issues arise when the service provider wants (or is obliged by the recipient of the service) to close a mere services deal where the supplier will be willing to enjoy the same veto rights available in a corporate joint venture. And indeed, according to scholars, it is arguable that a mere service provider might have any control on the management of a company.
What tax issues in outsourcing agreements?
The main issue with reference to outsourcing agreements structured as services agreements where the service provider wants to obtain the same protections proper of corporate joint ventures relates to the risk of requalification of the service provider as a shareholder of the company.
The consequence of such requalification is that service and license fees would be requalified as dividends that – depending on the relevant jurisdiction – are subject to a less favourable tax treatment. Therefore a potential tax fraud might be challenged to the service provider.
1,316 outsourcing agreements collectively valued $114 billion are set to expire in 2014 and, with the more stringent approach recently adopted by tax authorities, the issues above might become relevant. Therefore, as usual feel free to contact me, Giulio Coraggio to discuss. Also, if you want to receive my newsletter, please join my LinkedIn Group or my Facebook page. And follow me on Twitter, Google+ and become one of my friends on LinkedIn.
P.S. Negotiations of outsourcing agreements are sometimes a battle rather than a friendship like the one showed in the picture above. However the goal of the parties is to create a long standing relationship based on trust which is crucial for a proper provision of the service. Therefore strong contractual protections should be in place but also manageable during the life of the contract.